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Options Trading: Don't Program Yourself to Always Lose

Posted April 7, 2011

Topics: Finance & Investing

Do you have an exit strategy? Options traders -- especially those opening long positions -- have to fight against time, hoping for profits before expiration, and with enough movement to offset declining time value. The odds are not favorable, so knowing when to get out is just as important as knowing when to get in.

When you buy an option, you hope the price moves in the right direction (up for calls or down for puts). But if you buy four points of time value, the outcome four points from strike only lets you break even. You need more price movement than the initial cost plus strike, or you need a rapid price movement.

Even if you accomplish this goal, when will you get out. Some traders do not have an exit strategy so they are always going to lose.

Here is why:

1. If the option becomes profitable immediately, the tendency is to want to ride the wave to more profits.

2. If those profits later evaporate, the next tendency is to want to get back to the highest point. But even if that happens, the first tendency is going to kick back in. Conclusion: You can never sell when prices are moving favorably.

3. If the price moves in the wrong direction, you don’t cut losses because the tendency is to want to get back to the starting point. So there is no strategy to cut losses.

4. If prices do rebound in the long option, the original tendency -- to chase more profits -- goes into effect.

In other words, there is no scenario in which the long trader can get out, either with a profit or to cut losses.

The solution is sensible. Set a goal for yourself before entering the trade. The goal should be based on dollar amounts or percentages. For example, your goal might be:

            I will sell if the value of my option gains 50% or loses 50%.

Another method is based on dollar values:

            I will sell if the value of my option increases by $100 or decreases by $150.

The whole point is, you need to know when you have to exit the position, to take profits or to cut losses. Without this goal, you will have programmed yourself to lose each and every time. That probably is not what you want, unless you are trading options as some method of masochism. Don’t laugh, it might be the case for some traders.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches three options courses: “Swing Trading with Options,” “The Amazing World of Options,” and “Synthetic Options Strategies.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE newly-formed blog.